Ukraine: coal industry in crisis

To understand the impact of events in Donetsk and Lugansk on the Ukrainian coal industry, two main questions need to first be answered:

What was the situation in the country’s coal mining before 2014?

What was the role of those two regions in Ukraine’s coal market?

An updated energy strategy to 2030 assumed the nation would produce 115 million tons of coal per year in 2030; it would be self-sufficient in metallurgical coal; and it would continuously replace Russian natural gas with thermal coal as the major fuel for Ukraine’s thermal power plants.

Reaching 115 million tons of production assumed at least 135 million tons of annual capacity by 2030. In 2013 Ukraine’s 402 coalmines had a total capacity of 103 million tons per year. It was therefore a task to somehow launch new capacity for at least 32 million t between 2014 and 2030. Such a task required at least US$3.2-3.5 billion of investments – potentially from China.

From 2004 Ukraine was a net importer of metallurgical coal with Russian suppliers filling the annual gap of 6-10 million tons. The strategy of coal export growth was available only with metallurgical coal but it required huge investments in expansion of the capacity at the Ukrainian Black Sea ports.

The rise in domestic coal demand looked, at the time, to be a more reliable source of the growth in the industry. Due to the political instability in 2000-2010 Ukraine started the transition from gas-fired power plants to coal only in 2011, planning to reduce gas consumption by 30-32 billion cubic meters per year by 2018-2019 (that might boost demand for thermal coal by 18 million tons per year). This meant that it could reduce gas consumption by about 6 billion cubic meters per year by 4Q 2013 (in other words, to increase the demand in coal by 3 million tons per year).

Generally speaking, the Chinese government and companies were perceived to become the major future investors in the Ukrainian coal mining industry, including seaport expansion projects, new launches of coal mines and further transition of power plants from gas to coal. Thus in July 2012 the Ministry of Energy and Coal Industry of Ukraine signed an agreement with the China Development Bank for a $3.6 billion loan for the financing of gas-to-coal conversions and the construction of coal gasification plants. China is among the major contenders for the privatization of the few state-run coalmines and even thermal power plants in the country.

Looking at the positions held by Donetsk and Lugansk in the Ukrainian coal industry in 2013, it is not an exaggeration to say these two regions compromised the ‘coal heart’ of the country.

Donbass is the largest coal basin in Ukraine and Europe with total (commercial and prospective) reserves of 240 billion tons of bituminous coal and anthracite. Metallurgical coal made up more than half of the basin‘s reserves. Almost a quarter of all reserves are high-quality anthracite, while another quarter are thermal coal with high calorific value and low ash content.

Donbass provided 100% of metallurgical coal production and around 97% of thermal coal production in Ukraine in 2013, while two other coal basins (Lvovsko-Volynsky basin in western Ukraine and the Dneprovsky lignite basin west of Donbass) provided 100% of lignite and only 3% of thermal coal outputs. Donbass coalmines are located mainly in so-called Old Donbass (the central and northern parts of the Donetsk region and the southern part of the Lugansk region). Metallurgical coal was extracted mainly in the central part of Donetsk near Makeevka, Gorlovka, Donetsk, Krasnoarmeysk, Konstantinovka and a few other cities, as well as in the Krasnodar and Kadeevo districts of Lugansk. Thermal coal was mainly extracted in Antratsit, Lutugino, Lisichansk and Alchevsk districts of Lugansk.

Most of the country’s largest coal mining assets – both private (such as Pokrovskoye, formerly Krasnoarmeyskaya-Zapadnaya-1, Krasnodonugol, Zasyadko, Dobropolyeugol) and state-run (such as Makeevugol, Sverdlovanthracite, Rovenki-Anthracite, Luganskugol etc.) are located within the Old Donbass area. Out of Ukraine’s twelve coke-chemical plants (consumers of the metallurgical coal), seven plants are located in Donetsk and Lugansk, providing 66% of the total metallurgical coal production in the country in 2013.

Thermal power plants in Donetsk and Lugansk provided around 40% of the total thermal coal consumption in Ukraine in 2013.

Since 2013 and the start of hostilities between the Ukrainian government and the opposition, the Ukrainian government and private investors remain in control of certain coal mining assets in Donbass, with Pavlogradugol (in the Dniepropetrovsk region and owned by SCM Group) being the largest of them. They also control two of seven regional coke-chemical plants with 32% share in Ukraine’s metallurgical manufacture. In July all state-run coalmines controlled by the Ukrainian government stopped their work for an indefinite period.

The opposition controls 88 coalmines in Donetsk and Lugansk, including Pokrovskoye, Krasnodonugol, Zasyadko, Makeevugol, Dobropolyeugol, Sverdlovanthracite, Rovenki-Anthracite and Luganskugol accounting for around 70% of coal manufacture in Donbass. They also control five of seven regional coke-chemical plants with a 33% share in metallurgical coal production.

In 3Q 2013, the sharp decline of coal production in Donbass resulted in Ukraine boosting the import of Russian coal (including thermal coal) in the first two quarters of last year. In 2Q 2014 and 3Q 2014 Ukraine said it would refuse to buy Russian coal and attempted to import coal from the US and South Africa. However the challenge Ukraine met before when trying to increase coal export – namely the low capacity and depth of the Ukrainian Black Sea ports – now started to play against the active import of coal. The ports simply could not process the required volume of import (while all Russian imports still went by rail).

Meeting the threat of the energy crisis, Ukraine renewed the import of Russian thermal coal in the final two quarters of last year to supply thermal power plants across the country. By 1Q 2015 Russian coal made up about 40% in Ukrainian thermal coal supply.

Disregarding a discussion on the political aspects of the situation, the following looks at what can be done with the Ukrainian government and private investors towards improving the hard situation in the country’s coal market.

Obviously, the major way out is the implementation of Minsk-2 agreement, which may re-open the door to Ukrainian and foreign investors to all coalmines in Donbass.

Meanwhile, the supply of the national energy system with thermal coal has become the priority task for the government. Obviously, it cannot instantly boost thermal coal production at the mines controlled by the government or private investors; time and investments are required – and both are in deficit. Due to political reasons, the Ukrainian government does not want to increase the import of coal from Russia, which is an understandable position from the business point of view (Ukraine already is dependent on Russia for gas and oil).

The single alternative is to boost coal import from the US, South Africa and other countries. This however requires a fast resolution of the issues of low capacity and depth of the Ukrainian seaports. As a temporary measure, they may use smaller vessels (as do Ukrainian miners for EU export) but it may be inefficient for total replacement of the Russian import. In any case, Ukraine urgently needs to modernize at least one large seaport, making it capable of taking the large vessels used in transatlantic operations. It seems Odessa seaport was selected for such a role should the new Governor of Odessa succeed in privatizing this asset and attracting reliable foreign investment to fund the expansion project.

Another possible – though not the best – solution is to transit the power sector back to gas. The gas supply to Ukraine from Russia is a process that has strong political and financial support from the EU and the US. It seems that Ukraine will continue to receive the gas from Russia at a more or less acceptable price without any sharp declines in supply volumes. This therefore may guarantee the gas-fired power plants the potential to continue their work. In contrast, the coal supply is a game played by Ukraine alone, as even its close ally Poland refused to fund the supply of coal from Silesia to Ukraine. Thus if it is a choice to select between two options – Russian gas or Russian coal – Ukraine has much better negotiation positions for gas.

The situation with metallurgical coal is less dramatic as steel mills and coke-chemical plants have significantly reduced their production (thus lowering the total demand in metallurgical coal). However, it is not good for the competitive positions of the Ukrainian steelmakers, especially in the export markets, where their place is being re-occupied with suppliers from APAC and Russia.

The political tensions in eastern Ukraine have the visible economic measures to make coal mining industry suffer greatly.